Aggregate Risks and Aggregate Allocations

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What do asset markets signal about future macroeconomic developments? How are macroeconomic risks generated and allocated and what frictions may prevent a first-best solution? What are the appropriate policy responses to upheavals on financial markets? The proposed research seeks to contribute to answering these questions, pursuing three projects in particular. The first project investigates the interrelationship between macroeconomic shocks and financial markets empirically, identifying shocks by their explanatory power for forecast error variances. The second project investigates the allocation of macroeconomic risks and several frictions with the help of dynamic stochastic general equilibrium models, capable of delivering appropriate risk premia. The third project seeks to understand the 2008 financial crisis as a systemic bank run, in which tradeable bank assets become illiquid. It also examines the case for a fiscal stimulus in a financial crisis.Intellectual Merit of Proposed ActivityThe proposed research extends the existing literature in a number of dimensions. The first project provides a new method for identifying shocks based on their contribution to explaining future variance, which should be useful more generally. It applies this methodology to examine the interaction between key shocks moving asset markets and macroeconomic aggregates, thereby deepening our empirical understanding of these relationships. The second project extends and/or streamlines the literature, which seeks a joint modelfor asset markets and macroeconomic allocations. Generic formulations for preferences and technologies provide restrictions on elasticities which should prove generally useful. The role of key frictions and features shall be clarified. A DSGE model suitable for studying monetary policy, while delivering key asset market observations, extends the existing literature. The third project is motivated by recent events. While reminiscent of a classic bank run, a key difference is that the assets of shaky financial institutions are marketable at least in principle. The proposed research contributes to the literature of constructing a model of a systemic bank run, filling this gap in our understanding. The proposal furthermore contributes to the literature of the special role of fiscal policies during a financial crisis.Broader Impact of Proposed ActivityThe interrelationship between asset markets and financial intermediaries on the one side and macroeconomic behavior on the other as well as appropriate policy responses to disturbances in the financial sector have become a topic of considerable general interest. This research hopes to contribute to a deeper understanding of the issues involved, which may be of help for the relevant policy institutions.